How Options Really Work

Before you start options trading you need to understand exactly how options contracts work.  Because options are a little more complex than most other financial instruments, it's absolutely vital that you are fully aware of the way they are priced, how they are exercised, and how they are settled.

Regardless of what sort of options you are trading, what trading style you use, and what strategies you employ, you simply cannot expect to be successful without a fundamental understanding of how they work. We would therefore strongly recommend that you take the time to read the following information and related pages.

  • How Options are Priced
  • How Options are Exercised
  • How Options are Settled

How Options are Priced

There are two specific aspects of options pricing that you need to be familiar with. First is how contracts are actually valued and how the price is determined. There are two components that make up the price of an options contract: the extrinsic value and the intrinsic value.

Intrinsic value is relatively straightforward and easy to calculate. In simple terms, it's the real value of the option at that point in terms of any profit that could be made through exercising the option. For example, a call option based on the underlying security of stock in Company X with a strike price of $20 would have no intrinsic value if the stock was trading at $20 or less, because there is no profit to be made by exercising the option in those circumstances. However if the stock was trading at $25, then the intrinsic value would be $5 because the profit is effectively built into the contract .

Extrinsic value is basically the difference between the intrinsic value and the price. It's slightly more complex than that though and it's based on factors other than the price of the underlying security.

The other aspect of options pricing that you should understand is the price at which they are bought and sold at. When they are quoted on the exchanges they aren't quoted at a single price, but rather with a bid price and ask price. The bid price is the price that you can sell them for, and the ask price is the price that you can buy them for. The ask price is higher than the bid price, so every time you trade there's effectively a built in margin.

For more details relating to how options are priced, please read the following page – Price of Options.

How Options are Exercised

When you buy an options contract, you are buying the right to either buy or sell the underlying asset at the agreed strike price. If you decide that you want to act upon that right and enforce it, this is known as exercising the option. When you exercise as the holder of a contract, the writer of that contract is obliged to proceed with the relevant transaction. Some contracts allow you to exercise at any point (American style) while others can only be exercised on the expiration date (European style).

Trading options doesn't have to involve any exercising, because it's possible to make money simply by buying and selling at the right times and taking your profit that way. Indeed, many traders rarely, if ever, actually exercise and instead close open positions by buying or selling accordingly. However, there can be circumstances in which exercising is the right way to go.

Please read the following page for additional information on this subject – Exercising an Option.

How Options are Settled

When an options contract is exercised by the holder, there's a process that must take place for the writer of the contract to meet their obligations to the holder. This process is known as settlement, and it happens either when the holder of a contract exercises or if the contract is automatically settled upon expiration.

There are two types of settlement: physical settlement and cash settlement. Physical settlement is when the underlying asset is actually transferred between the two parties, whereas cash settlement is when the holder is paid out a cash amount equal to any profit they could theoretically make if the asset was being transferred.

You can read more about how options are settled on the following page – Options Settlement.